Why do cities and local governments in the United States proactively promote local economic development?
It is tempting to answer this question simply with “because this is their job”. But reality is more complex. Cities and local governments in the United States proactively promote local economic development because they have political and fiscal incentives to do so. Those incentives are not the same everywhere, though.
The political incentive for economic development
Politically, being able to attract new businesses to a city or county means more jobs for constituents, which in turn means more votes for the mayor and council members at the next election. And mayors and county supervisors from successful localities go on to be state delegates, governors, and beyond.
Fiscally, attracting more businesses and more residents means an expanding tax base and greater local tax revenue, which in turn allows the local government to make investments in infrastructure and services. Without a local budget that grows over time, being a local elected official is quite challenging. But a growing local economy and a growing population (with families moving in to fill the available employment opportunities) creates “fiscal space” for better local infrastructure and better services to all constituents—old and new alike—resulting in more votes at the next election.
As such, ensuring that local governments have a strong political and fiscal incentive to promote local economic development should be an important ingredient in a state’s economic development strategy.
The fiscal incentive for local economic development
The ability of a local government to promote local economic development is proportionately related to its functional powers and the size of its budget. The size of the fiscal incentive that local governments have to promote local economic development is closely related to the local revenues that it is allowed to collect. Unfortunately, revenue powers in most state governments are quite centralized, with the state government retaining most productive tax sources, and limiting the revenue space assigned to local governments.
The main revenue source assigned to local governments in the United States is the property tax, with local governments retaining 97 percent of property tax revenues. Although some state governments allow local governments to collect some general sales tax revenue (often through local surtax on the state sales tax: a so-called “local option” sales tax), state governments on average retain three-quarters (77percent) of general sales tax revenues.
Some states–including Florida, Colorado, and New York–provide greater revenue autonomy to their local governments, with local governments collecting roughly half of state and local revenues. However, on average, less than 40 percent (38.1 percent) of total state and local government revenues is collected at the local government level in the United States. In Virginia, this share is 35.7 percent.
Local revenue autonomy in Virginia
As a Dillon Rule state, local government revenue autonomy in Virginia is considerably constrained by state law. The Commonwealth has assigned the power to collect property taxes to the local government level. In addition, localities have the right to impose a one percentage-point local option sales tax, which is collected by the Virginia Department of Taxation on their behalf. All counties and independent cities in the commonwealth have opted into this local sales tax. In addition, local governments are permitted to collect a number of license taxes and other miscellaneous taxes.
The relatively limited amount of local revenue autonomy greatly reduces the incentive of local governments to be partners with the state government in promoting economic development. After all, beyond bragging rights, why would local government leaders provide—say—a million dollars’ worth of property tax concessions for a firm to locate in its community if the bulk of the fiscal benefits—the additional corporate income tax revenue (if any) and the individual income tax paid by the new employees—goes to the state level? The short answer is: they wouldn’t.
Don’t higher local taxes hinder economic growth?
Before proceeding, it is important to debunk a persistent myth. There is a “conventional wisdom” –heavily promoted by certain groups—that taxes (local or otherwise) are bad for economic growth. If this were true, all state and local governments would promptly set their tax rates to zero, and the places with higher local taxes would generally be poor.
Using Virginia data, the “conventional wisdom” that higher taxes reduce economic growth can readily be debunked, as the wealthiest places in the commonwealth (i.e., the more economically successful) also tend to be the ones with higher local tax rates. Compare on the left the wealthiest places in Virginia, based on real median household income, and on the right, local property tax rates.
The erroneous conventional wisdom misses an extremely important nuance. The consensus among the economists is that taxes are bad for economic growth unless the proceeds are used efficiently to provide local infrastructure and services. When tax revenue are well-spent on public infrastructure and services, the positive impact of public spending offsets the potentially negative impact of local taxation. There is a general consensus that local taxation is an essential element of the U.S. tax system and a necessary condition for local government stability and resilience.
To the extent that households and businesses are displeased with the mix of local taxes and local services offered by any locality, they are able to either vote for different local leadership or–in extreme cases–“vote with their feet” by relocating to any other local jurisdiction. Keyboard warriors aside, there is little evidence to suggest that local governments (especially in the higher-taxing parts of the commonwealth) are not doing a good providing public services or are failing to attract new residents and businesses, despite the challenges associated with being high-cost localities.
Local property taxes alone fail to provide a strong incentive for economic development
Taxation should not be one-size-fits-all, especially not in a state with considerable variations in income, geography, and voter preferences. It may not be appropriate to impose higher tax rate on households that prefer lower government spending, while businesses are willing to pay a premium for access to a well-educated labor force. Similarly, wealthier voters are willing to pay for better public services. As a result, a major challenge being faced by local governments in providing local services and pursuing economic development—especially in the higher-income parts of the state—is the limited autonomy they have to collect high-yielding local taxes. (Another challenge, to be discussed another day, is that the redistribution of resources through intergovernmental transfers places a considerable ‘tax’ on some parts of the commonwealth).
This challenge is closely related to the problem of local governments in Virginia having only a limited incentive to promote fiscal economic development. Under the current arrangements, local governments only benefit indirectly from local economic development through increased property tax revenues. Property taxes provide a relatively weak incentive for local governments: after all, there is no guarantee that the employees of a company that locates in City or County X buy homes in the same city or county. In Virginia’s metropolitan areas, it is almost guaranteed that a sizeable share of the economic and fiscal benefits of economic development will fall outside of any one locality’s jurisdiction. In addition, the property tax tends to function as a ‘quasi-user-fee’ for local government services, so that the increase in revenue from property taxes due to economic and population growth does not necessarily create unfettered fiscal space, but will need to be spent on the additional streetlights, teachers, and fire fighters needed to accommodate the new businesses and residents. In other words, the net fiscal benefit from economic development at the local level are relatively limited.
The state government faces a different fiscal equation: whereas the city or county government is on the hook for providing front-line services to households and businesses year after year, once a company locates in the commonwealth, the state government gets a major fiscal benefit each year thereafter through the state’s individual income tax, corporate income tax, and sales tax, with a very small (if any) direct increase in expenditure requirements.
Since locally elected officials are accountable to their constituents, you would not expect them to spend local resources when they do not perceive there to be a positive (fiscal) impact for their local constituents. The fact that local government officials act as rational economic actors—weighing policy choices based on the costs and benefits to the local community that has elected them—has apparently resulted in frustration among some state-level officials.
Local income taxes as a potential enabler of economic development and a source of local fiscal space
One potential way to encourage local governments to pursue a more proactive role in economic development is by enhancing the revenue autonomy of local governments in a way that strengthens the link between local revenues and local economic growth.
One specific win-win mechanisms that should be considered in Virginia is a local income tax, much like the local income tax in Maryland, where county governments can impose a local income tax rate up to 3.2 percent (on top of the state’s income tax rate of up to 5.75 percent. Like Virginia’s existing local-option sales tax, a local-option income tax would allow localities to set their own rate (up to a maximum ceiling) while being administered by the Virginia Department of Taxation. While the practice is less common in the South East and the Western United States, local income taxation is more common in the Mid-Atlantic states and parts of the Midwest.
The introduction of a local income tax in Virginia would provide a major incentive for local governments across the commonwealth to pursue economic development: after all, the local governments’ general revenue fund would benefit directly—through higher local income tax revenues—from increases in economic activity within their locality.
Greater local revenue autonomy would be a catalyst for greater local economic development, which would benefit the locality itself, but also, the commonwealth as a whole. After all, faster local economic growth would have a positive spillover effect on neighboring jurisdictions and the rest of the state: neighboring jurisdictions would likely ‘capture’ some of the population and revenue growth, and state tax revenues would increase as a result of the efforts of enterprising Virginia localities. In turn, since nearly half of the commonwealth budget is redistributed to the local level in the form of intergovernmental transfers or “aid to localities”, economic growth in one part of the commonwealth would benefit all.
An added benefit of the local income tax versus other local tax alternatives is that the income tax is likely a fairer tax instrument. The tax burden of a simple flat-rate local-option income tax tends to fall more on wealthier households who are better able to afford the tax (i.e., the tax is proportional or slightly progressive), whereas other local taxes such as the local sales taxes and local property taxes tend to be regressive (with lower-income household paying a larger share of their income in taxes). The progressivity of the tax is likely further aided by the fact that wealthier local jurisdictions are likely to adopt higher tax rates.
In contrast to other tax instruments made available to local governments in Virginia, such as the restaurant tax, a local income tax would minimize the potential for inequity and economic distortion by offering a broad tax base, while offering counties and cities the ability to generate meaningful revenue without setting an excessively high rate. In order to prevent an overall increase in the tax burden, the commonwealth government could even reduce the state income tax rate by the same amount as the local income tax ceiling.
Beyond its potential positive impact on local economic development and greater local revenue autonomy, a local-option income tax would likely be a political win-win (regardless of political view), especially when combined with a reduction of the state income tax rate. Taxpayers across the commonwealth would receive a state tax cut, while residents in localities that are willing to pay more for better local services would be able to attain a more optimal basket of taxes and local services without having to rely on inefficient or selective local taxes.
Virginia is one commonwealth, but it should not be one-size-fits-all.
Note: The feature image for this post is AI-generated. The economic analysis is not.
